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Chapter 7
Internal Controls
Internal controls consist of all the related methods and measures adopted within
a business to:
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Safeguard its assets from employee theft, robbery and unauthorized use;
and
Enhance the accuracy and reliability of its accounting records by reducing
the risk of errors (unintentional mistakes) and irregularities (intentional
mistakes and misrepresentations) in the accounting process
Internal controls are both preventive and detective. Preventive controls are
designed to keep thefts from occurring. Detective controls are designed to detect
thefts once they happen. Key internal control principles include:

Establishment of Responsibility
If possible, you want one person to be responsible for one task. That way
if something goes wrong, then you know who is responsible and who to
blame.

Segregation of Duties
Don’t let one person do everything. You want different people assigned to
related tasks. If one person does everything, then it is easy to steal, and
there is no one to spot another’s mistakes.
For example, one person should order goods; another should sign for the
receipt of goods; and a third should pay for the goods. If one person did
everything, he or she could arrange for the company to pay for inventory
that was never received.
Another example would be that one person should make a sale, another
should ship the goods, and a third should bill the customer. If one person
did everything, he or she could fail to fully bill customers for shipped goods
(for kickbacks or for sales to friends).
Another example would be to separate the job of receiving payments from
customers from the job of accounting for the receipts. If one person
receives and records payments from customers, he or she could pocket
the receipts while reporting the bills paid to the customers and reporting to
the company that payments are not yet received.
Another example would be to separate the job of making sales from the
job of authorizing credit. If one person does both jobs, he or she might
extend credit to inappropriate persons in order to increase his or her sales
commissions.
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Documentation Procedures
Procedures should be established requiring the use of documents.
Moreover, all documents should be prenumbered and accounted for. This
helps to prevent undocumented transactions from failing to be recorded. It
also helps to prevent documents from being lost.
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Physical, Mechanical and Electronic Controls
Physical controls help to safeguard assets.
For example, using safes and locked cash boxes helps to prevent cash
from being taken by employees. Use of locked warehouses, burglar
alarms, security cameras helps to prevent inventory from being taken.
Use of passwords on computers helps to prevent unauthorized tampering
with company assets and records. Use of time clocks helps to prevent
employees from coming late and leaving early.

Independent Internal Verification
The company checks to see whether there are any discrepancies in the
records of its employees. This is done regularly or on a surprise basis. It
is done by an employee independent of the person being checked. Any
discrepancies are reported to the management of the company.

Rotating Employees Duties & Requiring Vacations
The company should insist that every employee take a vacation. When
someone else does an employee job it is easier to spot discrepancies. If
an employee is stealing, they will never take a vacation for fear that a
discrepancy will be spotted. For the same reason, a company should not
let the same person stay in one job for long periods.

Bonding of Employees Who Handle Cash
Bonding companies insure a company against losses from theft by
employees who handle cash. The insurance company screens an
employee before insuring them. In addition, if any loss occurs, and
insurance company will vigorously prosecute all offenders and track them
down (like bail jumpers) in order to deter other potentially dishonest
employees.
Internal Controls Over Cash Disbursements
Cash received from sales in a store are handled by issuing cashier's a given
amount to be placed in the cash register (the change fund). Afterward, the
amount received from the public is compared to the cash register tape. To the
extent that any differences exist, the amount is charged to Cash Short and Over.
In the case of a shortfall:
D. Cash
Cash Short & Over
Cr. Sales Revenue
$980
20
$1,000
In the case of too much cash:
D. Cash
Cr. Cash Short & Over
Sales Revenue
$1,000
20
$980
At the end of the accounting period, the Cash Short and Over Account is treated
as an expense or miscellaneous revenue account.
Cash received in the mail from customers is noted on a remittance advice. If
amounts are stolen it will show up with inconsistencies between cash remittances
and amounts credited to customers. If the wrong amount is credited to
customers, the customers should complain. As noted above, companies should
separate those who handle the cash (a cashier's department), and those who
record the cash transactions (an accounting department).
Checks received in the mail are stamped "For Deposit Only", this prevents
someone other than the payee from depositing the check.
A voucher system should be used to make payments on liabilities of a company.
No check is made until a voucher is prepared by the accounting department and
approved by an official of the company. The check is then issued and given to
the creditor of the company. Electronic funds transfer (EFT) systems are used to
keep the cost of issuing checks down.
Petty Cash Fund
Sometimes a company has to pay cash for some expenses. To handle these
transactions, a company sets up a petty cash fund. The journal entry is:
D. Petty Cash
Cr. Cash
$100
$100
When cash is paid out of this fund, the recipient of the petty cash records how
much funds were received and for what purpose on a petty cash receipt form.
Later when the petty cash fund is replenished, you treat it as if you paid the
expenses recorded on the petty cash receipt forms:
D. Office Supplies
Store Supplies
Miscellaneous Expense
Cr. Cash
$50
40
10
$100
Bank Accounts
When you open an account, you will complete a signature card. This specifies
who is allowed to sign checks or withdraw money from the bank account. A
transaction register or check register lists every check written on the account.
A business check is often accompanied with a remittance form explaining why
the check is being paid. For example, it will identify that it is paying an invoice
dated on a particular date.
Once a month, the bank returns a company's canceled checks with the bank
statement. The bank statement shows the bank balance at the beginning of the
month, all additions and deductions during the month, and the balance at the end
of the month. A bank statement's end-of-month balance rarely agrees with the
balance in the company's books for that date. Thus, the accountant must prepare
a bank reconciliation to account for this difference and to locate any errors made
by the bank or the company.
The bank reconciliation begins with the balance per books and balance per bank
statement figures as of the bank statement date. Each figure is adjusted by
certain additions and deductions, thereby resulting in two adjusted cash balance
figures, which should agree.


The balance per books figure is adjusted by information that the
bank knew at the bank statement date but that the company did
not.
The balance per bank statement figure is adjusted by information
that the company knew at the bank statement date but that the
bank did not.
Examples of adjustments are as follows:

Outstanding checks are a deduction from the balance per bank
statement.






Deposits in transit are an addition to the balance per bank
statement.
Service charges by the bank appear on the bank statement and are
a deduction from the balance per books.
A customer's non-sufficient funds (NSF) check is deducted from the
balance per books.
Interest earned on a checking account is added to the balance per
books.
Miscellaneous charges are deducted from the balance per books;
miscellaneous credits are added to the balance per books.
If the bank is collecting promissory notes on behalf of the company,
a collection of a promissory note would be added to the balance per
books.
After the bank reconciliation has been prepared, adjusting entries must be made
so that the accounting records will reflect the new information supplied by the
bank statement.
Promissory Note collected by bank:
D. Cash
Cr. Note Receivable
$100
$100
Check returned from bank "Not Sufficient Funds":
D. Accounts Receivable
Cr. Cash
$100
$100
Service Charge for month:
D. Bank Service Charge Expense
Cr. Cash
$100
$100
Interest accrued on bank account:
D. Cash
Cr. Interest Income
$100
$100
Recorded amount of check received lower than actual amount (Book Error
– Need to reduce Cash and Account Payable by more):
D. Cash
Cr. Accounts Payable
$100
$100
Nature of Cash
Cash and cash equivalents include coin, currency, checks, money orders, and
money on deposit with banks and similar financial institutions. The money on
deposit is supposed to be available for unrestricted withdrawal. Deposits that are
restricted for under 90 days is considered cash.
Companies frequently have excess cash on hand for short periods of time.
These may be invested in cash equivalents. Cash equivalents are short-term,
highly liquid investments that are both:


Readily convertible to known amounts of cash; and
So near their maturity that their market value is relatively insensitive to
changes in interest rates.
Examples of cash equivalents are Treasury bills, commercial paper (short-term
corporate notes), and money market funds.
Cash and cash equivalents do not include cash that is not available for general
use, but rather is restricted for a special purpose. For example, landfill
companies are often required to maintain a fund of restricted cash to ensure that
they will have adequate resources to cover closing and clean-up costs at the end
of a landfill site’s useful life. Restricted cash is reported on a balance sheet as
“Restricted Cash” not part of “Cash and Cash Equivalents”.
Managing and Monitoring Cash
A business needs to have enough cash on hand to meet its cash needs on time
(e.g., make payments when required). It is better if the cash needs are met from
the company’s operations (no cost) rather than borrowing (interest cost).
Company treasurers or chief financial officers need to manage their cash receipts
and payments effectively. The following are basic principles of cash
management:
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Increase the speed of collection on receivables (e.g., offer sales
discounts).
Inventory ties up resources. Keep inventory levels low (e.g., just in time
inventory practices).
Delay payment of liabilities, but don’t pass up purchase discounts.
Plan timing of major expenditures so that you still have adequate cash to
meet current needs.
Invest idle cash to earn interest.
Cash Budgeting
A company should estimate its future cash receipts and needs in order to help it
manage its cash effectively. This is accomplished through a cash budget. A
cash budget usually covers a one-year or two-year period. It shows cash inflows,
cash outflows, and cash from financing when a shortfall is anticipated:
Cash Budget
Beginning Balance of Cash
Add: Cash Receipts (itemized)
Collections from customers
$168,000
Sale of Securities
2,000
Total Cash Receipts
Total Available Cash
Less: Cash Disbursements
Materials
$23,200
Salaries
62,000
Cash Selling & Adm. Expenses
94,300
Truck Purchase
30,000
Income Tax Expense
3,000
Total Cash Disbursements
Cash Deficiency
Add: Financing
Borrowings
Ending Cash Balance
$38,000
170,000
$208,000
-212,500
-$4,500
10,000
$5,500
Financial Statement Analysis
Financial analysts study how effectively a company manages its cash flow using
two ratios:
Ratio of Cash to Daily Cash Expense
This ratio gives the number of days that the company can operate without an
additional infusion of cash:
Cash and Cash Equivalents
------------------------------------------------Average Daily Cash Expenses
Free Cash Flow
Free Cash Flow provides an assessment of a company’s liquidity and financial
flexibility:
–
–
Cash Provided by Operations
Capital Expenditures
Cash Dividends
Free Cash Flow